Now that the City of Detroit has been given the green light to proceed with restructuring under the protections of Chapter 9 of the U.S. Bankruptcy Code that govern municipalities, potential large-scale cutbacks, including the pensions of city retirees and steep losses for unsecured creditors, are likely the order of the day.

Reading aloud from prepared text for more than one hour, U.S. Bankruptcy Judge Steven Rhodes ruled on December 3rd that Detroit is officially eligible for bankruptcy because it met the specific legal criteria required to receive protection from its creditors. As a result, Detroit now holds the title of ‘largest bankrupt city in U.S. history.’

Detroit is $18.5 billion in debt, and says retiree benefits and retiree healthcare account for half of its liabilities with $5.7 billion of debt stemming from retiree healthcare and an additional $3.5 billion in unfunded pension liabilities.

Although Rhodes ruled the city did not “negotiate in good faith” with its creditors, he called those negotiations “impracticable,” since many of the more than 100,000 creditors were unable or unwilling to negotiate in the first place.

As part of the restructuring, Rhodes also decided the city could cut pensions, ruling against an earlier argument by Detroit’s 23,500 retirees that Michigan's constitution allows for special safeguards that protect retiree health care benefits and pensions from being slashed. While Michigan’s constitution protects public pension benefits as contracts, those contracts can be impaired in a municipal bankruptcy, Rhodes determined.

Yet, Rhodes cautioned that his court would not necessarily confirm any plan of adjustment that impairs pension rights, saying the restructuring plan must take into account all creditors—including retirees—and weigh that against what is most judicious for the city.

The American Federation of State, County and Municipal Employees Council 25 (AFSCME) filed a notice of appeal claiming the judge made an error in ruling that federal bankruptcy law takes precedence over public employee pension protections entrenched in the Michigan constitution. Michigan Attorney General Bill Schuette called the judge’s decision disappointing and said he will file amicus briefs with the court reaffirming his support for protecting pensions. Other labor groups and Detroit’s pensions are expected to appeal as well.

Rhodes declined to stay the bankruptcy proceedings as appeals begin to proceed through the courts and said all motions to appeal his ruling must first be filed in bankruptcy court. He previously stayed all state court action in the case.

Now that Detroit has been declared ‘eligible’ for bankruptcy, Detroit emergency manager Kevyn Orr is finalizing a “plan of re-adjustment,” which is slated to be filed by early January. Prior to the bankruptcy ruling, Orr’s initial proposal, which offered unsecured creditors shares in a $2 billion note in exchange for $11 billion in unsecured debt, may be altered.

Other financially troubled municipalities with unfunded pension liabilities will be keeping a close watch on future developments in Detroit. Unlike employees who work in the private sector, public pensions are not protected by the federal Pension Benefit Guarantee Corp.

Even though some analysts predict the arduous process of proving bankruptcy eligibility alone will keep most municipalities from imitating Detroit, the ruling does provide a model on which other cities may try to follow in the future.

Quoted in a December 3, 2013 Reuters article about the bankruptcy ruling, Richard Ciccarone, president of Merritt Research Services, said this decision “could create more bankruptcies because it's a way to get out of pension contracts. It more than likely will mean that hard-pressed, stressed creditors with legacy liabilities will have to consider the option."

Robert Novy-Marx, an associate professor of finance at the University of Rochester’s Simon Business School calls the judge’s ruling “hugely important” in a December 3, 2013 Detroit Free Press article. “In terms of the legal landscape, it clarifies the fact even pension benefits can be impaired,” he said.

“That very much changes the conversation that workers and municipalities have going forward,” said Novy-Marx, who has expertise in public pensions. “Up until now, the workers have said we’re going to get paid no matter what. We’re not going to negotiate.”

Rhodes’ ruling also means that the Detroit Institute of Arts (DIA) is not exempt from the restructuring. The city-owned collection, which includes paintings by Vincent van Gogh and Henri Matisse among other prized possessions, is being evaluated by auction house Christie’s, since about 500 pieces could be affected by the bankruptcy, according to Detroit emergency manager Kevyn Orr. Christie's auction house estimates on a preliminary basis that artwork purchased by the City for the museum’s collection is worth up to $866 million.

Detroit is not the only U.S. city facing daunting pension obligations. Chicago faces a $20 billion pension shortfall, while the state of Illinois holds the dubious distinction of being the worst funded public employee pension system in the nation with almost $100 billion in unfunded pension liabilities. Illinois passed a long-awaited public pension reform on December 4, 2013, which was signed by the governor and is being challenged by the unions.

ABOUT THE AUTHOR: Mark Johnson, Ph.D., J.D.Mark Johnson, Ph.D., J.D., is a highly experienced ERISA expert. As a former ERISA Plan Managing Director and plan fiduciary for a Fortune 500 company, Dr. Johnson has practical knowledge of plan documents as well as an in-depth understanding of ERISA obligations. He works as an expert consultant and witness on 401(k), ESOP and pension fiduciary liability; retiree medical benefit coverage; third party administrator disputes; individual benefit claims; pension benefits in bankruptcy; long term disability benefits; and cash conversion balances. He can be reached at 817-909-0778.

ERISA Benefits Consulting, Inc. by Mark Johnson provides benefit consulting and advisory services and does not engage in the practice of law. December, 2013

While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.